Subprime Mortgage Crisis
What is Subprime lending?
Subprime lending is making the loans available to the people .where the interest rates are higher than the normal interest rates in order to compensate the higher credit risk.
A record was created from low quality subprime mortgage around 8% to 20% in 2004 - 2006. A high percentage of these subprime mortgages, over 90% in 2006 were adjustable mortgages. These two things showed that lower lending standards and higher riskier mortgages. The U.S households had become increasingly indebted i.e. the from 77% to 127% (debt to the disposable personal income).
Causes for the Subprime ?
· Inability of the homeowners to pay the mortgage amount
· The oversupply or one can say overshooting the demand of the residential premises that was required
· Risky mortgage products
· Increased power of the mortgage owners i.e. the people who took loan were given more rights& power
· High personal and debt levels of the corporate
· Bad monetary housing policies
· International trade imbalance
· Lack of government regulation
· Lack of credit risk facility
Three Important Factors that were seen in the crisis
· Private sector came in participation
· Banks entering into mortgage
· Unfair practices of the mortgage lenders
Looking deep in the crisis there were certain myths and assumptions!
That the realty prices will never ever come down
Analysis: It is always safe to assume that whatever goes up it has to come down in some way or the other, as the sector or demand grows people it attracts more people and when the sector or a particular thing starts gaining importance its bound to be under a scanner of the officials, bureaucrats, HNI’s, institutions and won’t be able to maintain the same growth throughout its life.
Free and open financial markets supported by sophisticated financial engineering would most effectively support market efficiency and stability, directing funds to the most profitable and productive uses!
Analysis: It’s nice to open up the financial markets for the investments but on the assumptions that they have the best technology ,big bucks CEO’s ,fund house’s manager’s, Big pockets Investment bankers, technical etc, would also be right and always give you returns whenever you give them the money. This is really just a myth which we wanted to bring it to you all that no one is perfect and one can predict the market on certain assumption but it’s wrong to think that they are the creators of those assumptions as they are not the only one in the country investing there are many others so conflict of interest plays a very important role.
Concepts embedded in mathematics and physics could be directly adapted to markets, in the form of various financial models used to evaluate credit risk!
Analysis: We would totally agree on the concepts of the physics and mathematics where to an extent it can be used for the measurement of credit risk but in order for complete risk analysis and sound system its worthless .You people just tell me how can a mathematics can give the thoroughness or the genuineness of an individual? Can it give the guarantee the answer is no, where it can’t predict the nature or the mood so this consideration was also at fault.
Economic imbalances, such as large trade deficits and low savings rates indicative of over-consumption, were sustainable!
Analysis: The country is in high debt and there low savings it’s the complete other way round should have been, where the trade imbalance was far less or surplus if assumed and instead of low savings, higher interest rate would be good to attract investor’s money to cut the trade imbalance.
Causes
Boom and out left with only flies in the realty market!
Lower interest rate, capital inflow of foreign funds and easy credit condition created an artificial demand, which created debt financed consumption .The ownership of households increased from 64%in 1994 to 69.2% in 2004. Subprime lending was a major contributor to this increase in home ownership rates and in the overall demand for housing, which drove prices higher. In the period of 12 yrs 97-06 the price rise in House was approximately 127%. During the two decades ending in 2001, the national median home price ranged from 2.9 to 3.1 times median household income. This ratio rose to 4.0 in 2004 and 4.6 in 2006. The house owners started to refinance their homes at lower interest rates. They started to refinance their personal spending by mortgaging the same property with the other party for the same property on the basis of rise in price .This lead to increase in consumption and the economy was high headed.USA household debt as a percentage of annual disposable personal income was 127% at the end of 2007, versus 77% in 1990. Where no efforts by the government to make efforts for the people’s savings there was increase in borrowings and spending. Debt burden rose to 127% v/s 77% .Where when you see the debt of the household is staggering $705billion in -74 to $7.4 trillion in – 00 to just anywhere near $15 trillion in -08.In 08 household spending increased this can be seen with the no’s -13 credit cards US household, where the shocking is that the cash which they are carrying is just 6% up from -74 when compared to debt of household it’s just miniscule. US debt to GDP increased from 46% -90’s to 73% -08 i.e. around $11trillion. U.S. mortgage debt almost doubled, and the amount of mortgage debt per household rose more than 63%, from $91,500 to $149,500. Credit made available to the borrowers, lead to price rise and eventually the quota of the unsold homes lead to the decline. Easy credit, and a belief that house prices would continue to appreciate, encouraged many subprime borrowers to obtain loan at adjustable-rate mortgages. These mortgages enticed borrowers with a below market interest rate for some predetermined period, followed by market interest rates for the remainder of the mortgage's term. Borrowers, who would not be able to make the higher payments once the initial grace period ended, were planning to refinance their mortgages after a year or two of appreciation. But refinancing became more difficult, once house prices began to decline in many parts of the USA. Borrowers who found themselves unable to escape higher monthly payments by refinancing began to default. Borrowers stopped paying their mortgages that but the supply of home was still intact, as they failed to realize what was coming for them was darker seen or must be thought by any one. There was very less demand and now the pinch was been felt by the sector where started to decline. Indirectly the mortgage backed securities saw a decline where loan given by the bank on the price of the asset. As the price declined value of ABS also declined and that was the downturn of the Banks. Which eroded quiet a net worth off their balance sheet? By mid 2008 the prices of the property declined by 20%.there were cases where the value of the equity was worthless or negative less than the value of their mortgages had just begun. 8.8 million Borrowers — 10.8% of all homeowners — had negative equity in their homes, a number that is believed to have risen to 12 million. By September 2010, 23% of all U.S. homes were worth less than the mortgage loan. It was secured where the borrower had limited obligation to the extent of the property if not been able to pay the liability. But the question here arises what is the effect of non repayment as the value of the property had also declined in the same time.
Property bought as a Speculative move!
It was observed in 2006, 22% of homes purchased (1.65 million units) were for investment purposes, with an additional 14% (1.07 million units) purchased as vacation homes. In 2005 it was observed 28% and 12%.The figures give a little manipulated idea actually 40% of residence for both years are at fault they were not bought as homes but as on speculation. As the market increased it attracted lot of investors and the speculators then left leaving the market with very less volatility.
High risk mortgage loans i.e. lending /borrowing practices!
As mentioned earlier, It’s the entire process that inculcated the crisis .Just before the crisis came into picture, the lending credit risk of an individual was not checked .The banks disbursed loans to high credit risk individuals, also issued to immigrants who dint have any documents .One can just imagine how ruthless was US banks and the system to increase the loan book .For more than half the lending it was the private players who had the securities. The mortgage amounted to $35 billion (5%of total origination) in 1994 raised to $600 billion i.e. 20%. The average interest rate of Sub Prime crisis and Prime/normal mortgage decline significantly. This was followed by the decline in the risk premium and credit standard which caused the boom all high butterflies later left with no air caused to its death.
When new borrowers are out of the market, to purchase at inflated prices, a price collapse can occur in the market segment inflated by excess debt, along with a dramatic reduction in liquidity in that market. This can then cause insolvency, bankruptcy, and foreclosure for those borrowers who came in late to that market. If widespread, this can then damage the solvency and profitability of the private banking system itself, resulting in a dramatic reduction in new lending as lenders attempt to protect their balance sheets from further losses. This in turn results in a contraction in the growth of the money supply, often referred to as a "credit squeeze" or a "drying up of liquidity".
The borrowers were offered loan incentives that also boosted the credit demand.
“Changes in the mortgage guidelines”
· First the stated income, verified assets (SIVA) loans came out
· Proof of income was no longer required
· Borrowers just needed to "state" it and show that they had money in the bank
· Then there was another amendment the no income, verified assets (NIVA) loans came out
· Whether the borrower is employed or not it was not taken into consideration
· It was just the money they required to show up at the end to get access to excess funds
· The qualification guidelines kept getting looser in order to produce more mortgages and more securities
· “No income No Asset” (NINA) loans are official loan products and let you borrow money without having to prove or even state any owned assets
· “Adjustable rate mortgage” ARM where the borrower had to pay only the interest amount for few initial years and the principal amount was not taken into consideration.
· “Payment option” PO this is the payment tool where the borrower can pay the interest in variable amount and the amount to extent unpaid will be added to the principal amount. It’s so illogical or not necessary that was initiated.
· Every 1 out of 10 borrowers had opted for the option payment this suggest that how the borrowers opted for the lowest payment that they made and the balance amount kept on piling up to the principal amount.
· Around 1/3rd of the ARM were in picture in 2006 had rates low to 4% but after a period the rates nearly doubled. When we look at this scheme for an Example a person who earns $10,000 and if they pay around $400 as interest but later it is the same situation they will have to pay $800 but no increase in the earning. Take an example if they earn $1000 how difficult will be for them.
· Mortgage underwriting is the process a lender uses to determine if the risk of offering a mortgage loan to a particular borrower is acceptable. Most of the risks and terms that underwriters consider fall under the three C’s of underwriting: credit, capacity and collateral where they failed take into consideration
· Government Sponsored Enterprises were at their weakest, and mortgage originators and private label securitizes were at their strongest
If one has to look in the entire case study we know the pool of money had increased but the investment strategy for the safe bets dint! Why this was not practiced we would totally blame on the Government of US.
Few facts more into detail we need to look at
As the prices of the property were increasing but the level of income was not increasing it was throughout flat. The average home cost nearly four times what the average family made. The condition was such that people checked into the house but defaulted on very first payment how funny is it, but that’s how it goes.
The Mortgage fraud just went on top of the head no one would have even thought off of course those who thought: Collapsing lending standards and which lacked regulation ,the mortgage fraud grew just imagine at 20 X times from 96-05 i.e. around $112 billion
Securitization which was done by the lenders at the end all was not well for them
The above Diagram is explained with an example where artificial names are given to every character to make it simple
Mortgage brokers- Goldman Sachs
Lender –Bank of America
Borrower – US citizen Mark
Issuer – Citi Bank
Servicer- JP Morgan
Investor – warren buffet
Trustee – Blackstone
Underwriter-Credit sussie
Credit rating-Crisil/CARE/S&P/MOODYS
Credit enhancement provider – Merryl lynch
Mark is in need of loan so he approaches Bank of America. There are two possible ways where Mark can obtain a loan if he has the documents with him he can approach to the bank directly or he can go to Goldman sachs .here Goldman sachs will co-ordinate with bank Of America and make Mark loan available .The best part here is that it can be the first time both the BOFA and GS are meeting for the first time and it is also that it is not necessary that later in future they will met each other , whatever was their part they played it and made loan available to Mark ,this loan is disbursed to Mark by taking security as his property for future default if was made by him. Mark monthly installment on the loan starts and makes payment to JP Morgan. In the mean while whatever loan mortgage property was taken by BOFA sells the loan to Citi bank .now the Citi bank has a tie up with Crisil, Merrill Lynch, Credit Sussie, and Blackstone. Now you all will be wondering why BOFA sold their loan to Citi it’s just that they transferred the securities to Citi and received cash from them and again BOFA was with full of liquidity so they can make more loans available .when the Citi received the loan /securities they sold it to the Warren Buffet .Warren buffet before making an investment he would check all the details about the rating given to the security, underwriters, trustees, credit enhancement provider. The Citi had a tie up with the Crisil as they obtained good rating for the securities there was a nexus between the Citi and Crisil, Merrill Lynch, Credit Sussie, Blackstone. Which encouraged warren Buffet to invest in the securities .JP Morgan received cash From Mark and with the help of Black stone where the managed the pooling of all the securities and funds which bought the crisis. The CDS &CDO instruments were used in the same manner which can be applied in the case.
Take Away from the case
· No background check by BOFA before disbursing the loan
· Warren Buffet why did he went into such an investment strategy?
· The total deal which was cracked by BOFA had all the clue and credit details of the Mortgage loan/security warren Buffet had no clue as he was at the end of the chain
· Lack of government intervention
· Lack of Government policy
· Nexus was formed between the Citi and Crisil, Merrill Lynch ,Credit Sussie ,Blackstone
· BOFA also hide the details of the credit risk from the Citi
The last leg
Government was parallelized with the policies
· Alternative mortgage transaction party act was introduced which allowed the property creditors to charge ARM
· Adjustable-rate, option adjustable-rate, balloon-payment and interest-only mortgages
· These were introduced which replaced the fixed rate and the amortization of mortgages in US
· Deregulation of the banking industry
· predatory lending (Unfair) occurred with the use of adjustable-rate mortgages
· the policies were to promote the affordable housing
· 90% of subprime mortgages issued in 2006 were adjustable-rate mortgages
· GSE’s (Government sponsored enterprise) started receiving tax benefits exemptions for purchasing mortgage securities which were given to low income groups.
· The United States Department of Housing and Urban Development that at least 42% of the mortgages they purchase be issued to borrowers whose household income was below the median in their area
· Target was increased to 50% in 2000 and 52% in 2005
· From 2002 to 2006, as the U.S. subprime market grew 292% over previous years
· HUD &GSE combined purchases of subprime securities rose from $38 billion to around $175 billion per year before dropping to $90 billion per year, which included $350 billion of Alt-A securities
· HUD & GSE sponsored through mortgage pools they sponsored, $5.1 trillion in residential mortgages, about half the total U.S. mortgage market
· GSE mortgage securities essentially maintained their value throughout the crisis and did not contribute to the significant financial firm losses that were central/main to the financial crisis. The GSEs participated in the expansion of subprime and other risky mortgages, but they followed rather than led Wall Street and other lenders into subprime lending
· The Glass-Steagall Act was enacted after the Great Depression. It separated commercial banks and investment banks, in part to avoid potential conflicts of interest between the lending activities of the former and rating activities of the latter.
· Because of the risk-taking culture of investment banking dominated the more conservative commercial banking culture, leading to increased levels of risk-taking and leverage during the boom period
· Community Reinvestment Act (CRA), with people direct knowledge of the Act encouraged lending to un creditworthy borrowers
· CRA was not a significant factor in subprime lending or the crisis. Many subprime lenders were not subject to the CRA. FROM THE RESEARCH PAPERS it indicates only 6% of high-cost loans—a proxy for subprime loans—had any connection to the law
· Loans made by CRA-regulated lenders in the neighborhoods in which they were required to lend were half as likely to default as similar loans made in the same neighborhoods by independent mortgage originators not subject to the law
There are many other things which we have not considered in order to keep it simple
Any queries will be answered please don’t keep any query to yourself will take care of it .
